Gordon Growth Model (GGM) Defined: Example and Formula

December 17, 2022December 17, 2022 Versha Gupta

Contents

What Is the Gordon Development Mannequin (GGM)?

The Gordon progress mannequin (GGM) is a system used to find out the intrinsic worth of a inventory based mostly on a future sequence of dividends that develop at a continuing fee. It’s a widespread and simple variant of the dividend low cost mannequin (DDM). The GGM assumes that dividends develop at a continuing fee in perpetuity and solves for the current worth of the infinite sequence of future dividends.

As a result of the mannequin assumes a continuing progress fee, it’s typically solely used for corporations with steady progress charges in dividends per share.

Key Takeaways

The Gordon progress mannequin (GGM) is a system used to determine the intrinsic worth of firm inventory.
It assumes that an organization exists ceaselessly and that there’s a fixed progress in dividends when valuing an organization’s inventory.
The GGM works by taking an infinite sequence of dividends per share and discounting them again to the current utilizing the required fee of return.
It’s a variant of the dividend low cost mannequin (DDM).
The GGM is right for corporations with regular progress charges, given its assumption of fixed dividend progress.

Gordon Development Mannequin System

The Gordon progress mannequin system relies on the mathematical properties of an infinite sequence of numbers rising at a continuing fee. The three key inputs within the mannequin are dividends per share (DPS), the expansion fee in dividends per share, and the required fee of return (ROR).

beginaligned &P = frac D_1 r – g &textbfwhere: &P = textCurrent inventory worth &g = textConstant progress fee anticipated for &textdividends, in perpetuity &r = textConstant price of fairness capital for the &textcompany (or fee of return) &D_1 = textValue of subsequent 12 months’s dividends endaligned

Supply: Stern College of Enterprise, New York College.

Significance of the Gordon Development Mannequin

The GGM makes an attempt to calculate the honest worth of a inventory regardless of the prevailing market circumstances and takes into consideration the dividend payout components and the market’s anticipated returns. If the worth obtained from the mannequin is greater than the present buying and selling worth of shares, then the inventory is taken into account to be undervalued and qualifies for a purchase, and vice versa.

Dividends per share signify the annual funds an organization makes to its widespread fairness shareholders, whereas the expansion fee in dividends per share is how a lot the speed of dividends per share will increase from one 12 months to a different. The required fee of return is the minimal fee of return traders are keen to simply accept when shopping for an organization’s inventory, and there are a number of fashions traders use to estimate this fee.

Assumptions of the Gordon Development Mannequin

The Gordon progress mannequin values an organization’s inventory utilizing an assumption of fixed progress in dividend funds that an organization makes to its widespread fairness shareholders. The GGM assumes that an organization exists ceaselessly and pays dividends per share that enhance at a continuing fee.

To estimate the intrinsic worth of a inventory, the mannequin takes the infinite sequence of dividends per share and reductions them again to the current utilizing the required fee of return.

Limitations of the Gordon Development Mannequin

The primary limitation of the Gordon progress mannequin lies in its assumption of fixed progress in dividends per share. It is rather uncommon for corporations to point out fixed progress of their dividends resulting from enterprise cycles and sudden monetary difficulties or successes. The mannequin is thus restricted to corporations exhibiting steady progress charges.

The second difficulty happens with the connection between the low cost issue and the expansion fee used within the mannequin. If the required fee of return is lower than the expansion fee of dividends per share, the result’s a detrimental worth, rendering the mannequin nugatory. Additionally, if the required fee of return is identical as the expansion fee, the worth per share approaches infinity.

Instance of the Gordon Development Mannequin

As a hypothetical instance, think about an organization whose inventory is buying and selling at $110 per share. This firm requires an 8% minimal fee of return (r) and pays a $3 dividend per share subsequent 12 months (D₁), which is predicted to extend by 5% yearly (g).

The intrinsic worth (P) of the inventory is calculated as follows:

beginaligned &textP = frac $3 .08 – .05 = $100 endaligned

Based on the Gordon progress mannequin, the shares are presently $10 overvalued available in the market.

Professionals and Cons of the Gordon Development Mannequin

Professionals

The GGM is usually used to set up intrinsic worth and is taken into account the best system to grasp.
The mannequin establishes the worth of an organization’s inventory with out accounting for market circumstances, which simplifies the calculation.
This simple method additionally gives a strategy to examine corporations of various sizes and in several industries.

Cons

What Does the Gordon Development Mannequin Inform You?

The Gordon progress mannequin makes an attempt to calculate the honest worth of a inventory regardless of the prevailing market circumstances and takes into consideration the dividend payout components and the market’s anticipated returns. If the GGM worth is greater than the inventory’s present market worth, then the inventory is taken into account to be undervalued and needs to be purchased. Conversely, if the worth is decrease than the inventory’s present market worth, then the inventory is taken into account to be overvalued and needs to be offered.

What Are the Inputs for the Gordon Development Mannequin?

The three inputs within the GGM are dividends per share (DPS), the expansion fee in dividends per share, and the required fee of return (RoR). DPS is the annual funds an organization makes to its widespread fairness shareholders, whereas the DPS progress fee is the yearly fee of enhance in dividends. The required fee of return is the minimal fee of return at which traders will purchase an organization’s inventory.

What Are the Drawbacks of the Gordon Development Mannequin?

The GGM’s primary limitation lies in its assumption of fixed progress in dividends per share. It is rather uncommon for corporations to point out fixed progress of their dividends resulting from enterprise cycles and sudden monetary difficulties or successes. The mannequin is thus restricted to corporations with steady progress charges in dividends per share. One other difficulty happens with the connection between the low cost issue and the expansion fee used within the mannequin. If the required fee of return is lower than the expansion fee of dividends per share, the result’s a detrimental worth, rendering the mannequin nugatory. Additionally, if the required fee of return is identical as the expansion fee, the worth per share approaches infinity.

The Backside Line

The Gordon progress mannequin is a well-liked system that is used to seek out the intrinsic worth of an organization’s inventory. Usually, when the mannequin’s calculation leads to a determine that is greater than the present market worth of an organization’s shares, the inventory is seen as undervalued and needs to be thought of a purchase. When the GGM result’s decrease than the present buying and selling worth, the inventory is seen as overvalued and needs to be thought of a promote.

A draw back of the Gordon progress mannequin is its assumption that dividend payouts develop at a continuing fee. This makes it helpful solely when contemplating the inventory of these choose corporations with dividends that match that assumption. As well as, ought to the system’s required fee of return be lower than the dividend progress fee, the outcome will likely be detrimental and of no worth.